Treasury Pushes OTC Derivative Regulation

By Lisa Valentine

In an oft-repeated quote, Warren Buffet called derivatives “financial instruments of mass destruction.” U.S. Treasury Secretary Timothy Geithner stopped far short of making an analogy between weapons and derivatives, but it is clear that the U.S. government has much disdain for the largely unregulated financial instruments that are mostly controlled by four large banks in the U.S.: JP Morgan Chase, Bank of America, Citigroup and Goldman Sachs.

“Because of their enormous scale and the critical role they play in our financial markets, establishing a comprehensive framework of oversight for the OTC derivatives market is crucial to laying the foundation for a safer, more stable financial system,” Geithner told the joint hearing of the House Financial Services and Agriculture Committee last Friday.

He derided market participants and investors who use derivatives “to evade regulation, or to exploit gaps and differences in regulation, and to minimize the tax consequences of investment strategies.” The goals of the regulations are fourfold, said Geithner: protect the financial system from instability; provide transparency and efficiency; prevent market manipulation and fraud; and protect consumers and investors from investing in complex financial instruments they don’t understand.

Geithner outlined how the government—specifically the Securities Exchange Commission (SEC) and U.S. Commodities Futures Trading Commission (CFTC)—would police OTC derivatives and improve the transparency of these dealings. In his written testimony, the word “all,” as in “all derivatives” and “all market participants,” was italicized for emphasis. These government agencies are casting a wide net that seeks to regulate every possible OTC derivative, both customized and standardized. It’s very doubtful that they will be successful in policing “all” derivatives, but that is the intent, nonetheless.

Here are the steps Geithner has outlined as being necessary for instilling discipline and stability into the OTC derivatives market:

• Require that all (U.S. Treasury’s italics, not ours) standardized derivatives be cleared through a centralized (regulated) exchange or electronic trade execution system.
• Make all derivatives standardized by changing the definition of what constitutes a standardized derivative and increase capital requirements. Any derivative that is accepted by a central counterparty will be considered standardized.
• All OTC derivative dealers and all major market participants should be subject to regulation and supervision.
• Provide regulators with access to transactions and open positions.
• Give the SEC and CFTC the power to enforce these rules and to have a role in tightening the standards for who can participate in OTC derivative markets. In other words, the SEC and CFTC aim to protect consumers and other “unsophisticated” parties from themselves.
• Push these regulations abroad to other countries.

It’s clear that OTC derivatives could use some policing. It makes no sense to regulate parts of the financial industry yet allow financial instruments such as derivatives with a gross market value of more than $20 trillion to remain unregulated.

However, as is true of much of the proposed regulation coming out of Washington, the measures are too draconian. In their efforts to reduce systemic risk, the Obama administration may well wind up forcing central clearing offshore as U.S. markets try to avoid the regulatory police. Geithner acknowledges in his remarks that derivatives bring “substantial benefits to our economy by enabling companies to manage risks.” This reform could negate many of those benefits.